CFA, Finance

Financial Asset and Real Asset | Full Understanding

Financial Asset and Real Asset

The success of any business is dependent upon the presence of assets. Assets are the lifeblood of any business. Thus, before we dig into financial and real assets let us understand the concept of assets.

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What is an asset?

An asset is something that contains economic value usually for future benefits. These are owned by individuals, companies, and governments as they often generate cash flows or revenue and also sustain production and growth in the future.

The business assets (owned by the companies) can be financial security, raw materials, property, and even a piece of machinery. Apart from these, there are some intangible assets like patents, royalties, and other intellectual property. There are personal assets (owned by individuals) that are house, car, home goods, etc.

What is a Financial asset?

A financial asset is a tangible asset that can easily be converted into cash. Some common examples are- stocks, bonds, mutual funds, notes receivables, bank deposits, trade receivables, etc. These assets claim on the underlying value of other types of assets such as real estate and properties. The main feature of this type of asset is that it has monetary value, but that value is not tangible until it is exchanged for cash. They do not necessarily inherit physical worth or even a physical form unlike land, commodities, properties, or other such tangible physical assets. Rather, the value of financial assets come from the market factors i.e. demand and supply in which they are traded, and also the degree of risk they carry.

The real-world example of financial assets is- In banks, financial assets include the worth of the outstanding loans it has made to customers. Capital One, the 10th largest bank in the U.S., reported $372,537,597 billion in total assets on its first-quarter 2019 financial statements of that, $247,090,748 billion were from real estate-secured, commercial, and industrial loans.

According to the International Financial Reporting Standards (IFRS), a financial asset can be:

  • Cash or cash equivalent
  • Equity instruments of another entity
  • Contractual right to receive cash or another financial asset from another entity or to exchange financial assets or financial liabilities with another entity under conditions that are potentially favorable to the entity.

Financial Assets are measured at both amortized cost and fair value depending upon the nature of the holding. Thus, Under IFRS, they are classified into 4 broad categories:

  1. Held For Trading: refers to a category of financial assets that are acquired primarily for the purpose of selling in the near term. These are held or a short period of time. These are measured at fair value and any unrealized gains and losses are recognized as profit or loss on the income statement.
  2.  Available For Sale: refers to debt and equity securities that are not classified as the remaining types. These are measured at fair value.
  3. Held To Maturity: refers to a category of financial assets that are acquired primarily to hold it till maturity. These are measured at amortized cost.
  4.  Loans and Receivables.

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What is a Real asset?

A real asset refers to the value-generating physical asset that has an intrinsic worth. Intrinsic value means the exact value of an asset as determined by factors such as substance, location, function, acquisition costs, and other properties. The common examples of real assets are land, building, inventory, precious metals, natural resources, commodities, etc. They are suitable for inclusion in most diversified portfolios because of their relatively low correlation with financial assets, such as stock and bonds.

The real-world example of real assets is- In a 2017 report, asset management firm, Brookfield cited a global value of real asset equities totaling $5.6 trillion. Of this total, 57% was of natural resources, 23% of real estate, and 20% in infrastructure.

A real asset is categorized into three categories:

  1. Real Estate: REITs, commercial real estate, and residential.
  2. Natural Resources: Energy, Oil & gas, MLPs, timber, agriculture, solar, mining, and commodities.
  3. Infrastructure: Transportation (roads, airports, railroads), utilities, telecommunications infrastructure

Real assets are appealing to investors for the following five reasons:
• High current income
• Inflation protection
• Equity appreciation
• Low correlation to equity markets,
• Favorable tax treatment.

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Financial Assets Vs. Real Assets:

The financial assets and real assets can be differentiated on the following basis:

  1. Valuation: The real assets have intrinsic value, on the other hand, financial assets derive their value from a contractual claim on an underlying asset that may be real or intangible. Some financial assets have the capability to appreciate in value.
  2. Liquidity: The real assets are less liquid than the financial assets that are we can’t convert them into cash as quickly we could convert the financial assets since they are usually more cumbersome to exchange as their markets are not as efficient and populated. Financial assets are comparatively more liquid because of more convenience and efficiency and also have a proper marketplace for its trading.
  3. Growth: The real assets show sluggish growth. Such as owning a building (a real asset)- can be less valuable over time due to depreciation. Whereas, financial assets show continued growth and increased value as in cash reserves, stocks, bonds, etc.
  4. Purpose: Real assets are used to produce goods and services to generate revenue. Financial assets generate income or wealth among investors which are used to purchase real assets.
  5. Inflation Hedging: When the investment is done in low yielding bonds (financial assets), there is a big risk. Real assets, on the other side, are well-protected as their income and values are prone to grow along with inflation. Thus, they provide good protection against inflation risk.
  6. Balance sheet: The real assets appear only on the asset side of the balance sheet. Whereas, financial assets can appear on both sides of the balance sheet.
  7. Trade: Real assets are difficult to trade as they don’t have a competitive and efficient exchange while financial assets are independent of their location.

 

AUTHORS: Disha Agrawal and Bhagyashree Chandak

About the Authors:

Disha Agrawal is an Economics graduate and presently pursuing an MBA with a specialization in Financial Administration from the Prestige Institute of Management and Research, Indore. She is a keen learner and is intrigued by financial markets. She is committed to her work and strives for continuous improvement.

Bhagyashree Chandak aspires to become a research analyst and use the best of her knowledge.

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